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Is that a hole in your IPO?

I like to hike a few kilometres, pick up a free newspaper at Staples, and settle into the local Tim Hortons for a coffee. While reading the paper during one of my trips I discovered that Tim Hortons itself was on sale. Indeed, the Canadian donut icon recently sold shares to the public in what is known as an initial public offering or IPO.

On March 24 Tim's stock debuted on the TSX under the ticker symbol THI after Wendy's sold 15% of its stake, mainly to institutional investors, at $27 per share. When the public started trading Tim's shares they quickly shot up to a high of $37.99 on very strong demand. Unfortunately, Tim's stock proceeded to fall 12.9% from the high and ended the day at $33.10. Nonetheless, if you were lucky enough to get in at the IPO price of $27 you'd be sitting on a nice profit of 22.6%.

Most of the $27 shares were sold to institutional investors who in turn quickly sold them to the public and pocketed their gains. As is usual, the bulk of hot IPO stock went to the brokers' best clients and other insiders. Only the dregs were left for main street investors. After all, institutional investors (think hedge funds) generate huge commissions for brokers and when it comes to handing out perks like hot IPO shares these big traders demand a big slice of the pie. The process might not be equitable but it has been this way for a long time.

It also nicely illustrates why most main street investors should avoid IPOs entirely. Regular investors rarely get quality IPO shares before public trading begins. On the other hand, buying at sky-high prices when trading starts can set up long-term investors for a big fall.

Professor Jay Ritter of the University of Florida has collected a vast array of historical data on IPOs. Ritter's research indicates that, much like Tim Hortons, IPOs typically move smartly higher from the IPO price in the first day of public trading. First day gains for U.S. IPOs averaged 18.1% from 1960 to 2005. In Canada, first day IPO gains averaged 6.3% from 1971 to 1999.

While Professor Ritter tracks first day IPO gains, he also follows the new companies for the next five years. Five-year average annual gains for U.S. IPOs, after the first day of trading, came in at 10.7% from 1970 to 2003. At first glance a 10.7% gain might seem great but IPOs trailed far behind similar stocks. Over the same period, stocks of a similar size (by market capitalization) outperformed the IPOs by an average of 4.1 percentage points annually which is a huge difference.

The lesson is fairly clear: in most cases main street investors should avoid IPOs after they start trading. I had foolishly thought that the internet bubble would have dissuaded a generation from chasing hot IPOs but it seems that hope springs eternal. A few outsized gains from the likes of Google and many investors are right back to chasing after the next hot thing. Just remember, history is against you when buying stocks shortly after they have gone public. While you may snag a few outsized winners, the losers are likely to dominate overall returns and lead to underperformace.

On the other hand, stocks can become great bargains a few years after first being listed. Very often IPOs crater when initial lofty expectations are not met. Provided that these broken IPOs have real businesses with decent fundamentals, they can represent great values.

Speaking of fundamentals, how does Tim's stack up? At the close of March 28, Tim's traded at $30.52 per share which would put its price-to-sales ratio at 4, its price-to-earnings ratio at 32, and its price-to-book-value ratio at 7.7. None of which are particularly attractive. At the same time, McDonald's had a price-to-sales ratio of 2.1, a price-to-earnings ratio of 16.8 and a price-to-book-value ratio of 2.9. Based on its lofty ratios, Tim's shareholders are expecting significant growth from the company. Canada's favourite donut shop had better deliver or Tim's shares will likely become as attractive as day-old coffee.

At present prices, I'll be sticking to Tim's fresh brew and I'll avoid its stock. But who knows? A bit of Tim might be a much better bargain a few years from now.

Initial Public Offerings: International Insights
Returns on IPOs during the five years after issuing

First published in May 2006.

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